1. National Income Accounting

2. roberto.fini@univr.it2 Introduction Why do we study the national income accounts? 1.National income accounting provides structure for our macroeconomic theory models 2.Introduces statistics that characterize the economy Output defined in two ways 1.Production side: output = payments to workers in wages, capital in interest and dividends 2.Demand side: output = purchases by different sectors of the economy  as per accounting, output measured via demand and production equal in equilibrium Output typically measured as GDP = value of all final goods and services produced within a country over a particular period of time.

3. roberto.fini@univr.it3 Production Side of the Economy The production side of the economy transforms inputs (labor, capital) into output (GDP) –Inputs referred to as factors of production –Payments to these factors are referred to as factor payments The relationship between inputs and outputs is defined by the production function  (1) where Y = output, N = labor, K = capital –“Output is a function of labor and capital,” where the functional form can be defined in various ways –The production function is crucial to the discussion of growth theory in chapters 3 and 4

4. roberto.fini@univr.it4 From GDP to National Income Use the terms output and income interchangeably in macroeconomics, but are they really equivalent? –There are a few crucial distinctions between them: 1.Capital wears down over time while it is being used in the production process  Net domestic product = GDP – depreciation »NDP is the total value of production minus the value of the amount of capital used up in producing that output »NDP is usually 89% of GDP 2.Businesses pay indirect taxes (i.e. taxes on sales, property, and production) that must be subtracted from NDP before making factor payments  National Income = NDP – indirect business taxes »Indirect business taxes account for nearly 10% of NDP »National income is roughly 80% of GDP

5. roberto.fini@univr.it5 Components of Demand Total demand for domestic output is made up of four components: 1.Consumption spending by households (C) 2.Investment spending by firms (I) 3.Government spending (G) 4.Foreign demand for our net exports (NX) The fundamental national income accounting identity is (3)

6. roberto.fini@univr.it6 Consumption Consumption = purchases of goods and services by the household sector –Includes spending on durable (ex. Cars), non-durable (ex. Food), and services (ex. Medical services) –Consumption is the primary component of demand Consumption as a share of GDP varies by country –Figure 2-2 compares consumption as a share of GDP for the U.S. to Japan Figure 2-2

7. roberto.fini@univr.it7 Government Government purchases of goods and services include items such as national defense expenditures, costs of road paving by state and local governments, and salaries of government employees Government also makes transfer payments = payments made to people without their providing a current service in exchange –Ex. Social security, unemployment benefits –Transfer payments are NOT included in GDP since not a part of current production –Government expenditure = transfers + purchases

8. roberto.fini@univr.it8 Investment Investment = additions to the physical stock of capital (i.e. building machinery, construction of factories, additions to firms inventories) In the national income accounts, investment associated with business sector’s adding to the physical stock of capital, including inventories –Household’s building up of inventories is considered consumption, although new home constructions considered part of I, not C Gross investment included in GDP measure, which is net investment plus depreciation

9. roberto.fini@univr.it9 Net Exports Accounts for domestic purchases of foreign goods (imports) and foreign purchases of domestic goods (exports)  NX = Exports – Imports –Subtract imports from GDP since accounting for total demand for domestic production NX can be >, <, or = 0 –U.S. NX has been negative since the 1980’s  trade deficit Fig. 2-4

10. roberto.fini@univr.it10 Some Identities: A Simple Economy Assume national income equals GDP, and thus use terms income and output interchangeably Begin with a simple economy: closed economy with no public sector, output expressed as Y  C + I (4) Only two twings can do with income: consume and save, national income expressed as (where S is private saving) Y  C + S (5) Combine (4) and (5): C + I  Y  C + S (6) Rearrange (6) I  Y – C  S (7) Or: investiment = savings

11. roberto.fini@univr.it11 Some Identities: Adding G and NX When add the government and the foreign sector, the fundamental identity becomes Y  C + I + G + NX (8) Disposable (after-tax) income, YD, is income minus tax and plus transfer: YD  Y + TR –TA (9) But YD is even what consumers split between C and S when have a public sector: YD  C + S (10) If rearrange (9) and substitute (8) for Y, then: Y + TR –TA  C + I + G + NX (11) Substituting (10) into (11): C + S –TR + TA  C + I + G + NX (12) Rearranging: S – I  (G + TR – TA) + NX (13)

12. roberto.fini@univr.it12 Budget deficit and Net exports TA – (G + TR) ≥ 0 Or: TA ≥ G + TR NX > 0 If export > import NX = 0 If export = import NX < 0 If export < import

13. roberto.fini@univr.it13 SIBDNX 1.000 00 8501500 1.0009000100 1.000950150- 100

14. roberto.fini@univr.it14 Measuring Gross Domestic Product GDP = the value of final goods and services currently produced within a country over a period of time –Only count final goods and services  NO DOUBLE COUNTING Ex. Would not include the full price of a car AND the tires bought by the manufacturer for the car  tires = intermediate goods –Only count goods and services currently (in the time period being considered) produced & excludes transactions involving used goods Ex. Include the construction of new homes in current GDP, but not the sale of existing homes –Only count goods and services produced within a country, regardless of the ownership/nationality of the producing firm Ex. Include the sale of a car produced by a Japanese car manufacturer located in the U.S. in U.S. GDP

15. roberto.fini@univr.it15 Problems of GDP Measurement There are three major criticisms of the GDP measure: 1.Omits non-market goods and services –Ex. Work of stay-at-home mothers and fathers not included in GDP 2.No accounting for “bads” such as crime and pollution –Ex. Crime is a detriment to society, but there is no subtraction from GDP to account for it 3.No correction for quality improvements –Ex. Technological improvements are beneficial to the economy, but nothing is added to GDP to account for them  Despite these drawbacks, GDP is still considered one of the best economic indicators for estimating growth in an economy

16. roberto.fini@univr.it16 Nominal vs. Real GDP NGDP is the value of output in a given period measured in current dollars –NGDP in 2007 is the sum of the value of all outputs measured in 2007 dollars: –  if GDP is to be used as a measure of output, need to control for prices RGDP is the value of output in constant dollars  scaled by a based year price, so that any change in GDP is due to change in production, not prices –If P B is the price in the base year for good i, RGDP in 2007 is:

17. roberto.fini@univr.it17 NGDP 1996 NGDP 2006 RGDP 2006 Good A1 for $ 1,002 for $ 2,002 for $ 1,00 Good B1 for $ 0,503 for $ 0,753 for $ 0,50 Total2 for $ 1,505 for $ 6,255 for $ 3,50

18. roberto.fini@univr.it18 Inflation and Prices Inflation, , is the rate of change of prices: where P t is today’s price and P t-1 is last period’s price Additionally,, or today’s price equals last year’s price, adjusted for inflation If  > 0, prices are increasing over time  inflation If  < 0, prices are decreasing over time  deflation How do we measure prices? –For the macroeconomy, need a measure of overall prices = price index –There are several price indexes, but most common are CPI, PPI, and the GDP deflator

19. roberto.fini@univr.it19 Price Indexes: GDP Deflator GDP deflator is the ratio of NGDP in a given year to RGDP of that year –Since GDP deflator is based on a calculation involving all goods produced in the economy, it is a widely based price index that is frequently used to measure inflation –Measures the change in prices between the base year and the current year Ex. If NGDP in 2006 is $6.25 and RGDP in 2006 is $3.50, then the GDP deflator for 2006 is $6.25/$3.50 = 1.79  prices have increased by 79% since the base year

20. roberto.fini@univr.it20 Price Indexes: CPI (consumption prices index) CPI measures the cost of buying a fixed basket of goods and services representative of the purchases of urban consumers –Measure of the cost of living for the average household Differs from GDP deflator in three ways: 1.CPI measures prices of a more limited basket of goods and services (only household goods and services) 2.The bundle of goods in the consumer basket is fixed, while that of the deflation is allowed to vary 3.CPI includes prices of imports, while GDP deflator only considers those goods produced within the country

21. roberto.fini@univr.it21 Price Indexes: PPI (production prices index) PPI measures the cost of buying a fixed basket of goods and services representative of a firm –Captures the cost of production for a typical firm –Market basket includes raw materials and semi-finished goods PPI is constructed from prices at an earlier stage of the distribution process than the CPI PPI signals changes to come in the CPI and is thus closely watched by policymakers  Over long periods of time, the two measures yield similar values and trends for inflation

22. roberto.fini@univr.it22 Unemployment The unemployment rate measures the fraction of the workforce that is out of work and looking for a job or expecting a recall from a layoff –Important indicator of well- being of an economy as being without a job suggests a reduction in income and purchases –Optimal unemployment rates differ from country to country  optimal unemployment rate linked to the potential level of output for a given economy (see figure 2-8) [Insert figure 2-8 here]

23. roberto.fini@univr.it23 Interest Rates and Real Interest Rates Interest rate = rate of payment on a loan or other investment over and above the principle repayment in terms of an annual percentage –Cost of borrowing money OR benefit of lending money Nominal interest rate = return on an investment in current dollars Real interest rate = return on an investment, adjusted for inflation If R is the nominal rate, and r is the real rate, then we can define the nominal rate as:

24. roberto.fini@univr.it24 Exchange Rate Each country has its own currency in which prices are quoted –In the U.S. prices are quoted in U.S. dollars, while in Canada prices are quoted in Canadian dollars and most of Europe uses the euro Exchange rate = the price of a foreign currency –Ex. The British pound is worth U.S. $1.84 Floating exchange rate  price of a currency is determined by supply and demand Fixed exchange rate  price of a currency is fixed –Ex. A Bermuda dollar is always worth one U.S. dollar